Q1. Limitations of the IS-LM model ? What happened to islm model when money supply increases ?

Ans. Limitations of the IS-LM Model: At any point of these curves the equilibrium condition in the corresponding market is
Limitations of ISLM true, but only at the point where the two curves intersect, both equilibrium conditions are
Both the simple income-expenditure model and the quantity theory of money engage in drastic satisfied. We can see this intersection in the following graph:
aggregation. The quantity theory of money aggregates the economy into only two markets, the
market for money balances and the market for all other things. The simple income-expenditure
model involves an equally drastic but different aggregation, to a market for goods and services
and a market for all other things. Then each, by Walras' Law, ignores the second market and
focuses on only one market. These drastic aggregations make sense if the main source of Q2. What affects IS-LM model?
problems in a market economy arise in only one sector and the problems that are evident in other
sectors are simply reflections of problems that originate in that one sector. A year after the Characteristics of the IS-LM Graph
publication of the General Theory, John Hicks proposed ISLM as a less dramatic aggregation
that he saw as a more general case of both the quantity theory and the simple income-expenditure The IS-LM graph consists of two curves, IS and LM. Gross domestic
model. Part of its popularity this model, which has reigned as the standard macroeconomic product (GDP), or (Y), is placed on the horizontal axis, increasing to the
model for half a century, undoubtedly lies in its ability to present macroeconomics in terms of a The IS and LM curves undertake changes due to many factors, such as different kinds
right. The interest rate, or (i or R), makes up the vertical axis.
model with exactly the same structure and mechanics as the model of supply and demand. of economic policies. These variations will explain the changes in the values of
Though the ISLM model is a fundamental model of macroeconomics, seldom do The IS curve depicts the set of all levels of interest rates and output production and of interest rates taking place in the economies.
macroeconomists try to estimate the parameters of the model and use it to predict the future (GDP) at which total investment (I) equals total saving (S). At lower For instance, if there is an increase in government spending, which is considered
course of GDP. There has been at least one attempt to estimate the importance of fiscal and interest rates, investment is higher, which translates into more total a fiscal policy, the IS curve will shift to the right, as seen in the graph in the left. This
monetary policy with equations similar to the equation one attains when one solves the model for
equilibrium income. However, many economists have argued that such an approach could not output (GDP), so the IS curve slopes downward and to the right. happens because more government spending means more production for any interest
capture the subtleties of how the economy works and thus do not give reliable estimates.1 rate. This shift, as seen in the adjacent graph, will consequently change the equilibrium
The LM curve, however, is affected by changes in the price level, from point E1 to point E2, with a greater level of output, but also at greater interest rates.
The fact that economists have not used the ISLM model in their attempts to numerically predict shifting to the left when prices rise and to the right when they fall. This
the effects of policy suggests that ISLM has weaknesses. The first of these is the question of
whether or not ISLM is meant as a long-run or short-run model. If it is meant as a long-run is because, holding the nominal MS constant, rising prices decrease real
model, then its prediction that equilibrium can exist at any level of output is controversial. ISLM money balances, which we know shifts the LM curve to the left.
aggregates the economy into three markets: goods, money, and all other. This aggregation makes
sense if nothing interesting happens in the "all-other" market, if it simply adjusts passively to Any change (decrease in government consumption, increase in taxes,
changes in the goods and money market. Included in the passively adjusting sector is the decrease in consumer confidence - that, for a given interest rate,
resource market, even though many economists point to the labor market as a sector that does not
readjust rapidly.
decreases the demand for goods creates a shift of the IS curve to the left.
Consumption goes down, leading to a decrease in output/income. The
ISLM predicts the equilibrium can be at any level because it assumes, as does the simple decrease in income reduces the demand for money. Given that the On the other hand, if we consider a monetary policy, such as an increase in the money
income-expenditure model, a passive supply. Sellers produce whatever is demanded, and all supply of money is fixed, the interest rate must decrease to push up the supply, the curve that shifts will be the LM curve, as seen in the graph in the right. An
adjustment to changes in demand are in the form of changes in output and none of the adjustment demand for money and maintain the Equilibrium. increase in the money supply will decrease the interest rate, shifting the LM curve to the
is in the form of changes in prices. Adjustment cannot be in the form of price changes because
the price level does not enter the model. Since changes in prices are the primary way markets right, thus increasing output.
adjust in microeconomic theory, the failure of ISLM to say anything about prices is a serious
weakness.